Academic background in accounting; MBA/CPA/JD. Headed a corporate pension fund; served as CFO for insurance company; established title/transactional firm; served as REIT CEO; former professor; served on profit and non-profit boards; currently share management responsibilities for hedge fund;... More

Who would have thought that The Stones were cutting edge advocates of selling options? After all these years, it finally dawned on me that Mick and Keith devoted this song to the propensity for option prices to “run” back to their strike price, and eventually expire worthless. Of course, they were also telling people to “get off their cloud” well before cloud computing became the newest rage.

The purpose of this article is to acquaint the reader with one of the elements used to price options-time. In a way, this component would seem to be intuitively simple. Perhaps the reason for the perceived simplicity is that many are familiar with the traditional real estate option. Generally, the plain vanilla real estate option creates a contract where a property owner will, for a fee, grant a potential buyer an option to buy subject property for a set price, within a stated time period. It is anticipated that the price of the option will vary, and the chief determinant of that variation is time. This aspect is readily understood, as an owner of property will refuse to encumber his property, unless adequate consideration is paid to compensate for a given time interval. And, as everyone knows, if the option is not exercised, the property owner will pocket the option money.

In the typical real estate scenario, the buyer probably has a legitimate interest in buying the property. But, during real estate bubbles, the buyer may want to “flip” the option to someone else and collect a fee for selling the option. Whatever the circumstance, if one were asked to ‘value’ the subject option on a daily basis, the value ascertained would no doubt reflect a linear amortization. Thus, the stated price of the option, divided by the number of days in the option period, would yield a daily value. On any given day, the preceding day represents a value proportionately greater than the next day, and so on. So, the tick of the clock and the passage of days are quite predictable, as the option decays in linear fashion. We can conclude that there is absolutely no ‘sensitivity’ to any external event. Suppose that on the morning of the last day of the option contract, developer announces major development plans for the immediate area. The announcement causes real estate values to skyrocket in the surrounding area, including the subject property.

In order to put time on our side we must understand risk and the concept of mathematical expectancy. In the above real estate example, we altered the facts to allow for a spike in value. In the final analysiseven the simple real estate option isn’t linear in reality- although, for accounting purposes, linear amortization is the norm. Suppose that a mere rumor surfaced about the development, as opposed to a definitive announcement. Or, to take another perspective, assume that the subject property was suddenly re-zoned in such a way as to lower its present value.

HICKORY DICKORY DOCK – OPTION TRADERS BET ON THE CLOCK

Both the buyer and seller of an option are betting on the clock. The buyer of an option wants enough time for the option to gain more than he paid for it. On the other hand, the seller hopes to simply run out the clock. In short, the option seller is betting on either a static or decaying universe. (As an interesting aside, the Second Law of Thermodynamics gives the edge to decay, or entropy). In any event, however, time transforms and shapes risk. The game will always begin at a point defined as ‘now’, and continue until some specified date in the future.

As to the subject of options, studies show that most options expire worthless. There is some debate as to the exact percentage, as well as the assessment methodology, but even a conservative number indicates an expiration ratio of some seventy percent. If a casino is perfectly happy with a winning ratio of fifty-one percent, a ratio approaching even the most conservative option expiration estimate would make for some very happy casino owners.

THE DAYS OF OUR LIVES

“Like sands through the hour glass, so are the days of our lives.” MacDonald Carey

Mr Carey probably had options on his mind, as he so elegantly and poignantly spoke those words for so many years. In dealing with the concept of time via option risk, we must change our perception of the speed at which the grains of sand flow through our ‘hourglass.’ Specifically, while we know that a 30 day option must expire on or before the clock runs out, the sand can actually accelerate or even recapture some grains before the ultimate result.

Imagine a giant warehouse, full of thousands upon thousands of clocks. All of these clocks are set to sound their alarm at precisely the same time. But, to an observer, something is terribly inconsistent. It appears that every clock is either too fast or too slow to possibly chime in unison at the specified time. Yet, we know that all of the thousands of clocks will converge, finally sounding a cacophony of chimes-at the precise moment. If we had an ‘hourglass’ that was converted to a thirty day structure, we could go away for the requisite time period and return to find that all of the sand had filtered from the top portion of our massive time piece, to the bottom. Supposethat we left a video camera to record the second-by second movement of the sand. What a strange and curious video we would encounter.

Even though the ‘days of our lives’ run on a strictly linear process, our time-piece is non-linear, as are the thousands of clocks in our warehouse. Thus time is somewhat of an illusion when we suspend the rules of linearity. Of course, as The Guess Who emphatically state, when there is no more time, there truly is no more time. Sothe game will end at the buzzer, as expected, and all clocks will chime in final harmony. It can be said that we perceive ‘time distortion’ thru the relative position of volatility. At various points along our thirty day time journey, it will seem that we travel at different speeds. At times, it appears that we walk in slow motion, and at other times, we travel on a rocket. But, despite our own particular clock or mode of travel, we can never completely reach our destination ahead of time. On the other hand, we are allowed to freeze our clock or cut our trip short.

NOT EVEN THE ROCKS LIVE FOREVER

A pessimist might point out that we begin to die at birth. It is certainly the case though; that an option will begin to die at the moment it is contracted. It should come as no surprise that there is a precise mathematical equation that reflects this fundamental law. In fact, Fischer Black and Myron Scholes brought a mathematical approach to options pricing in 1973, with the publication of their seminal piece in ‘The Journal of Political Economy.’ Robert Merton extended the model, and a Nobel Prize in Economic Services was awarded in 1997 for their efforts. Of course, genius alone is no defense against an often bewildering market, as evidenced by Merton and Scholes’ links to the Long-Term Capital Management debacle.

And, I’ve known math doctorates that can pontificate on options pricing methodology, but who somehow can’t seem to parlay that knowledge base into profitable trading strategies. So, just as some truly great musicians can play by ‘ear,’ so it is that one can become a very successful options trader, without possessing a strong mathematical background. Perhaps, the best advice is given by Jesse Livermore, as reflected more recently by Paul Tudor Jones:

“…I am leery of traders who have never lost it all. I think that intense feeling of desperation that accompanies such a horrifically deflating experience indelibly cauterizes great risk management reflexes into a trader’s very being.”

With that admonition in mind, the more mathematically inclined might read the appropriate sections dealing with the concept of ‘theta,’ in “Applied Math for Derivatives,” by John S. Martin. (See in particular pages 337-40/Sec. 12.5.4). The author provides the equation for calculating decay, and provides illustrations, including graphs, depicting the non-linear aspects relative to option decay). Of course, there are any numbers of option text-books that discuss this subject.

My suggestion is that you get a “feel” for non-linear decay by selling a covered call against 100 shares of stock that you own. If that isn’t viable at the moment, pretend that you either buy or sell a call of a stock that interests you, and carefully study the theta-and total value-of that option for thirty days. Draw an intraday graph, and save your coordinates to plot on a thirty day chart. At the end of that time, compare your project with a graphical illustration in an options textbook. Again, theta is the term used to describe the time decay associated with option decay. Theta is presented as a negative number, such as -.25, which simply means that an option contract with said theta will decay at a rate of .25 per day. The rate of decay is a function of the square root of the option. So, the rate of decay, as we’ve noted, is not linear. As one might intuitively expect, a longer-dated option decays at a slower rate than an option set to expire in two weeks.

Please remember, though, that you are attempting to isolate one component, for study purposes, and that interim fluctuations in the total price of the option will be a function of all the variables in the pricing model. In other words, you are attempting to learn about how the liver works, while recognizing that the other organs in the body are just as vital.

THETA MANAGEMENT AND COMMON MISPERCEPTIONS

It’s probably reasonable to assume that most people, and particularly those with a degree of market experience, realize that time and risk are intimately related. Increased time in the markets translates to a greater degree of risk. Of course, market risk can be hedged.

But, given what we know about option decay, are there more refined ways to think about the design and implementation of optimal strategies? Can we actually apply some of the traditional concepts of game theory to portfolio or trading management?

This is a complex-and provocative-topic, and only a cursory perspective is offered at this point- given time and space limitations, but feel free to ask questions in the comment section below . But let’s begin by addressing an extraordinary fallacy that appears repeatedly in various financial blogs and articles. These articles are not academic papers by any means, but nonetheless, they probably do substantial damage to traders and investors. The fallacy referred to is actually a mixture of ‘post hoc’ homilies and inadequate training/experience of numerous financial pundits.

These fallacies include:

The selling of an option is a one-dimensional process by which the seller of a given option is “locked” into the results flowing there from;

These are two quite superficial-and distorted comments that appear time and again when options are discussed, if not maligned-particularly by non-experts in the field. The above are somewhat interrelated. So, are options really a zero-sum proposition?

I think it more precise to simply state that there is an approximate symmetry, but only within an initial one-plane dimension. A zero-sum result is a consequence of staying within this one-dimensional plane. In the option universe, multiple dimensions exist. There are other reasons to discount the zero-sum perspective, which are beyond the scope and purpose of this article. However, if you realize that, in reality, the so-called ‘person’ on the other side of your option transaction is little more than a fiction, you begin to understand the real game.

The other person at the moment of this mythical transaction, is a computer ledger. The market maker must accept your bet and hedge accordingly. As an example, if you take $100 cash and deposit it in your checking account, does that mean that said $100 resides in your account? Of course not! Just as your bank deposit does not reflect the exact physical currency initially entrusted by you, so it is with any type of currency exchange. The real estate contract of purchase and sale, which is often used to explain options, is, as we noted previously, terribly misleading.

Complex option strategies form patterns and structures that change from moment to moment. Yet, in a complex, bounded structure, we may observe patterns that are orderly in space and disorderly in time and others orderly in time and disorderly in space. And because options are derivative instruments, virtually all patterns constitute a set of “Russian dolls”- that is to say, we expect to find fractals. Volatility, much like heat in relation to the boiling point of water, will represent a zone from a steady state (except for time decay), to a pattern that oscillates within the prescribed boundary. This boundary is pre-determined by the strategist. All points within the strategy set, and the impact thereof, are confined within this zone. Knowing the boundary limits allows for fine-tuning. It is the fine-tuning or adjustment alternatives, deployed at the right time, which can create a differential advantage over forces that appear random.

FINAL THOUGHTS

If we are short an option, we are not locked in to an unwanted assignment, should the market not be in our favor as expiration approaches. An option can be ‘reset’ much as one can turn over an hourglass, and the game can continue-so the concept of expiration is highly misleading, and compels the novice to abandon positions at a loss. In theory, the game has no end, and I’ve seen documented records where one persistent trader rolled out of a position for 2 1/2 years-finally winning the game. One way of thinking about this is to realize that a short option can always be reincarnated, whereas a long option, as it decays, will vanish from the universe forever.

Bear in mind that the purchase of an uncovered long option requires that an event occur. The seller of an option, as noted above, wants nothing to happen. In that regard, note as follows:

Buying an option also requires an informed opinion as to the elements that determine the price of said option, especially implied volatility (the value of an option can actually decrease even where the stock moves up).

The following is a guest post by John Douglas, who enjoys intelligent discussions around writing and focuses on portfolio enhancement through options.

“The Shadow of a Paradox”

This series of articles attempts to create new dimensions for thinking about, and comprehending advanced investing and trading strategies. The approach differs in that perspective and philosophy are essential starting points. Our simple premise is that technical information and an unlimited source of “how to” articles has done little or nothing to assist individuals in managing their money. Given the voluminous amount of freely available information, which ranges from fundamental and technical analysis to complex option strategies, the daunting question still remains:

Why is it that investors sell low and buy high, just like a broken record that keeps repeating over and over?

Why do investors make the same mistakes time and time again?

The answer to the above questions cannot be lack of information. Indeed there may be too much information. The sheer volume of spoken and written commentary, combined with the fragmentary delivery of this information, may serve to confound and confuse-not enlighten. The market itself lurches and gyrates to a seemingly random pattern and even a highly rational mind, one that admits of the existence of chaos and disorder, finds limited confidence in broader horizons.

Yet, one has only to look back and realize that any number of optimal opportunities existed. If only these opportunities could be discovered by logical analysis-before the obvious postmortem. The annoyance is enhanced all the more when a sane, reflective mind discovers-too late-that the answer was there all along. Why was it not so obvious? The answer to this riddle requires a multi-dimensional approach.

OF PARADIGMS AND PENUMBRAS

Let us consider that a workable definition of the term “paradigm” encompasses a minimum of assumptions and a maximum of conceptual precision. And, let’s say that a shadow may be opaque, or that we know that there are shadows within shadows-as can be observed in planetary analysis-often described as a penumbra.

And, for now, let’s simply note that an option is a derivative. It ‘derives’ its characteristics from an underlying instrument. So, you might visualize an option as a shadow of something else- a silhouette, or a two dimensional representation of something.

Shadows change in dimension relative to the position of the sun on a given day, and change in relation to the rotation of the planet on its axis. There are times when an object will cast a giant shadow, and times when little or no shadow can be observed. Sometimes, it appears that we have more than one shadow. Shadows appear a bit different in a fog. These tendencies can be described mathematically, and Greek letters have been used as an abbreviated way to communicate and depict the continuous change of these shadows, as components that describe changes in option values. But, more on that later.

Shadows are all around us. The contemplation of shadows appears throughout art and writing. Plato’s “Allegory of the Cave” is perhaps the most famous piece of philosophical inquiry. It seeks, in part, to understand perception, where one is limited to the observation of shadows. At another level, one might suggest that the mind encounters a degree of difficulty sorting thru illusions versus reality. Plato held that the fleeting things that constitute this world are degenerating copies of something permanent. Nonetheless, Plato embraced mathematics as the ultimate reality. In fact, posted above the door to Plato’s academy were these words: “let no one enter here who is ignorant of mathematics.”

This dichotomy between shadows and illusions, on the one hand, and reality on the other, has persisted for the duration of our species. For a more contemporary way of expressing the subject matter, we can turn to Judy Collins, who reveals, thru her song “Both Sides Now,” that it’s about seeing both sides-and perhaps a bit more:

‘I’ve looked at clouds from both sides now

From up and down and still somehow

It’s cloud’s illusions I recall

I really don’t know clouds at all.’

But the introspection grows as the contemplation intensifies:

“I’ve looked at life from both sides now

From win and lose and still somehow

It’s life’s illusions I recall

I really don’t know life at all.”

Perhaps all the financial experts and money managers should go away, isolate themselves, and really contemplate these lyrics.

The point is that there is much to learn about trading by immersing ourselves in philosophy, mathematics and music. Therefore, to begin our discussion of options, as most texts do, serves no useful purpose. Our perspective is somewhat different. But, an enlightened perspective will positively impact the manner in which we begin to learn.

Ultimately, we want to approach investing and trading from a game theory dimension, and we want to embrace randomness as an enduring “shadow.” We want to look for paradox, and we adamantly seek facts that are diametrically opposed to our gut feelings. And, we must be vigilant in ignoring the siren call of certainty. It is a dangerous distraction. Instead, we agree with Piet Hein’s simple, but elegant words:

“A bit beyond perception’s reach

I sometimes believe I see

That life is two locked boxes, each

Containing the other’s key.”

As we close out the introduction to this series, let’s take note of one more topic that receives a lot of media hype. Specifically, we are advised, if not chided, into purchasing various software packages that allow us to ‘back test’ or ‘paper trade.’ Well, despite the new age technology, we will embrace the teaching of Jesse Livermore:

“I have heard of people who amuse themselves conducting imaginary operations in the stock market to prove with imaginary dollars how right they are. Sometimes these ghost gamblers make millions. It is very easy to be a plunger that way. It is like the old story of the man who is going to fight a duel the next day.”

His second ask of him, “Are you a good shot?”

“Well,” said the duelist, “I can snap the stem of a wineglass at twenty paces,” and he looked modest.

“That’s all very well,” said the unimpressed second. “But can you snap the stem of the wineglass while the wineglass is pointing a loaded pistol straight at your heart?”

You might want to keep this in mind, as you rack up the easy money in the “virtual” world.

THE ENEMY WITHIN

As indicated, the purpose of this paper is to set forth a different perspective by which to understand a rather complex subject. To some extent, it’s not that the subject is so complicated, but fuzzy definitions and colloquialisms probably do more to deter understanding, than to facilitate useful information. In short, it is critical that our paradigm reflect appropriate usage of Occam’s razor- entities should not be multiplied beyond necessity. To the extent possible, we seek to determine if what appears to be complicated flows from surprisingly simple underlying programs.

Recall that Lewis Carroll’s White Queen would have defended everyone’s right to believe six impossible things before breakfast. Know, then, that the market can believe all sorts of improbable, if not impossible things, as you plan for your trading day or horizon. The process by which we form a belief or opinion has been studied at great length, over a long period of time, and it’s a topic that requires a great deal of thought.

A BRIEF PRIMER ON NEUROBIOLOGY

There are several billion neurons in the circuits of one human brain. The number of synapses formed among those neurons is at least 10 trillion, and the length of the axon cables forming neuron circuits totals something on the order of several hundred thousand miles. Within one second in the life of our minds, the brain produces millions of firing patterns over a large variety of circuits distributed over various brain regions. The elementary secrets of mind reside with the interaction of firing patterns generated by many neuron circuits, locally and globally, moment by moment, within the brain of a living organism.

So, our “wiring” is both intricate and amazing-yet, the issue of decision-making is a baffling subject. As the work of Amos Tversky and Daniel Kahneman demonstrate, the objective reasoning we employ in day-to-day decisions is far less effective than it ought to be. Antonio R. Damasio (M.D., Ph.D., and M.W. Allen Professor of Neurology at the University Of Iowa College Of Medicine) indicates: “To put it simply our reasoning strategies are defective…the fragile instruments of rationality need special assistance.”

It is worthwhile-no, it is mandatory- to study the works of Tversky and Kahneman. But first, a notable quote from G.K. Chesterton:

“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

A QUICK REVIEW OF PROSPECT THEORY

Consider this mental exercise, which was first reported in 1979. Subjects were asked to choose between an 80% chance of winning $4,000 and a 20% chance of winning nothing versus a 100% chance of receiving $3,000. Even though the risky choice has a higher mathematical expectation-$3,200-80% of the subjects chose the $3,000 certain. This represents a risk-averse perspective.

Kahneman and Tversky then offered a choice between taking the risk of an 80% chance of losing $4,000 and a 20% chance of breaking even versus a 100% chance of losing $3,000. Now, 92% of the respondents chose the gamble, even though its mathematical expectation of a loss of $3,200 was once again larger than the certain loss of $3,000. This asymmetrical pattern appears consistently in a wide variety of experiments.

Consider the following experiment, which was conducted some time later:

“Imagine that a rare disease is breaking out in some community and is expected to kill 600 people. Two different programs are available to deal with the threat. If program A is adopted, 200 people will be saved; if program B is adopted, there is a 33% probability that everyone will be saved and a 67% probability that no one will be saved. Which program would you choose?”

COMMENT

The risk averse person will prefer Plan A’s certainty of saving 200 hundred lives over Plan B’s gamble, which has the same mathematical expectancy but involves the risk of a 67% chance that everyone will die. The results of the tests reflected that 72% of the subjects went with Program A. But, suppose the same problem is posed differently. If Program C is adopted, 400 of the 600 people will die, while Program D entails a 33% probability that nobody will die and a 67% probability that 600 people will die. (Note that the first of the two choices is now expressed in terms of 400 deaths rather than 200 survivors, while the second program offers a 33% chance that no one will die. When presented this way, Kahneman and Tversky found that 78% of their subjects were risk-takers and opted for the gamble-they could not tolerate the prospect of the sure loss of 400 lives).

The important thing to note is that this behavior is inconsistent with “rational” decision-making. The major driving force is loss-aversion. Note the words of Tversky as he sought to explain this curious behavior:

“Probably the most significant and pervasive characteristic of the human pleasure machine is that people are much more sensitive to negative than to positive stimuli…Think about how well you feel today, and then try to imagine how much better you could feel… There are a few things that would make you feel better, but the number of things that would make you feel worse is unbounded.”

The following is a guest post by John Douglas, who enjoys intelligent discussions around writing and focuses on portfolio enhancement through options.

In a recent article, I discussed an approach to trading and investing which underscores critical analysis as well as a refined philosophical perspective. In this article, I will discuss a very recent option strategy, which handled the volatility of the market quite profitably.

Given time and space, I must assume some basic level of competency in trading options. Otherwise, I would be forced to repeat material available in any options textbook.

WHAT’S IN A NAME? A GENETICALLY MODIFIED IRON CONDOR

Options traders are very familiar with the iron condor strategy. An analogy I use is a tennis match, where two players battle it out, within fixed boundaries. Technically, one would select a stock or index, and establish a combination which consists of a bear call spread and a bull put spread. In very general terms, one creates opposing forces, and confines the playing field to desired parameters. The mindset is such that one has no preference as to the “winner”, but simply hopes to charge a fee for renting out the playing field. Ideally, the game is “rained out” and there are no winners or losers.

This concept, in and of itself, is difficult for most people to understand. It means that you don’t have a dog in the fight-you are, in essence, the casino. You will always prevail on one side or the other-that’s the worst case. The management and adjustment of the uncooperative side tests the skill and imagination of the trader.

Just recently, I established an iron condor, utilizing BIDU spreads. Now, the purist might argue that iron condors are best used on boring, low volatility stocks. That’s because such stocks, at least in theory, offer a higher probability of having both sides of the trade expire worthless. Thus one would pocket the premium accruing from both sides.

Been there, done that and I don’t blindly follow textbook convention. I tend to take another road and seek out high volatility stocks, recognizing upfront that I will have to manage one side or the other. Furthermore, I don’t concern myself with someone else’s nomenclature. So I use the term “iron condor” merely as a reference point. In practice, I will alter the DNA of the iron condor molecule, often creating an amorphous, mutated animal. My bank account could care less how the strategy is classified.

BIDU presents an interesting case study, as the subject trade is very recent-in fact it is still in play as of this writing.

To set the stage, the trade was established by:

Selling the ATM calls/puts (145 at the time)

Using the 150/140 strikes as the “wings.”

The objective is to have both sides expire worthless

Or take profits on one side, and adjust the other side, or trade against it.

July expiration options were used. Almost immediately, the market experienced a sell-off, presumably in response to an Ireland downgrade. More likely, however, the budget ceiling debate probably played an important role as well. So, in less than 24 hours the short call side was profitable, with roughly 80% of the maximum gain available. The short puts were, of course, running in the other direction. Note that when the position was established, it was delta neutral ( or reasonably close). Ten positions were initially established.

Given the quick move, the decision was made to capture all of the profit accrued in the short calls. The next move, however is most instructive, as it reflects an individual trading philosophy that traditional structures can-and should-be modified in such a way that fundamentally changes the entire trade.

Specifically, an immediate decision was to short 2,000 shares of BIDU, and then reducing that position in increments of 500 shares. Note that the decision was made to push the “petal to the metal” early in the sell off phase, and then lighten up. This is the complete opposite tactic of the novice, who will short an initial small amount, discover to his delight that he is making money, and then decide to add to the short position. This is, as indicated, totally wrong. The novice will now be whipsawed, and is likely to surrender his gain (and will probably retreat at a loss), simply because he lacked the courage of his conviction-at precisely the moment he should have gone for the jugular. Remember that the short position is now covered by three components:

The profit already booked via closing the short calls

The upside long calls remain as ultimate buffers

The short puts are still decidedly in the negative.

The fairly quick trade in shorting BIDU resulted in a gain that would exceed the maximum downside position, which was reflected by the short put side of the iron condor. When the profitable short call position was added in, the strategy was extremely profitable. As to the short put position, there was absolutely no downside to leaving them in place, and await the GOOG earnings announcement.

Fortunately, GOOG hit a homerun, and the short puts that were negative, turned substantially positive. The initial 10 positions had remained in place, and the decision was made to close all positions at .50. The reason is that this action provided a substantial gain, but it was anticipated that a modest spike back up in pricing would afford another opportunity to trade the short puts. As it turned out, 10 puts were sold at .90, and held until .12, creating a bit of cream to top off a profitable few days of trading.

Note that BIDU has weekly options, so the decision was made to establish a new hybrid or modified iron condor, by bumping up the short put parameters, and doing likewise with the short calls. However, the condor “flock” was altered by setting the strategy or formation with a 2:1 short put/ short call ratio. BIDU continued to perform in a rational manner over the next few days-especially for a Chinese internet stock. It demonstrated a continued daily rise, with little volatility. The decision was made to clip half the profitable short puts, bringing the ratio back in line with 1:1. Now, the total profit was exceptionally high, as well as secured, so the decision was made to simply await the earnings announcement. (Incidentally, we correlated a 154.60 stock price with our option parameters, and closed half the short put position at that point).

BIDU’s earnings announcement closely tracked GOOG, with the stock surging in after- hours trading. The positions open at this juncture were the 150/140 short put spread. As the after- hours closed, the stock made a 6.7% increase to $167.06. The short puts were closed after the market opened. Note that prior to the earnings announcement, implied volatility kept the 140 long puts from eroding, and the short puts at 150 remained somewhat constant as well. This behavior is typical for option prices as earnings announcements approach. Some option traders avoid earnings, but perhaps the decision should depend on the entire historical context, and the profit (or loss) incurred to date.

CONCLUDING THOUGHTS

If one simply looked at a recent chart of BIDU (located above), it would be difficult to understand how a substantial profit could have been made by shorting the stock. Yet, the iron condor allowed a quick exploitation when the market engaged in one of its PIIG tantrums. Once the profits derived from the short positions were realized, it became much easier to play for the whipsaw.

Bear in mind that the post-short strategy never gave BIDU a chance to recoup-by selling off yet again. The short puts that were established to play earnings, i.e. the 150/140 strikes, still protected against an Armageddon scenario. The 150 puts were closed for a substantial profit as indicated, but the decision was made to establish a bear call spread using the 160/170 strikes. Ten positions were opened, with a maximum profit of $4,600, and loss of $5,400. Simultaneously, 20 of the July 29 160 puts were sold (and closed within a couple of hours). Part of the dynamic with the 160 puts recognized two factors: (1)volatility collapse, which relates to post-earnings deflation, and (2)the expiration of weekly options on July 29-just a few days away. Note also that the existing long puts were left in place for both margin and hedging purposes. Further, the new bear call spread also served as a hedge. It is anticipated that the 160 puts can be traded until expiration, and that the September bear call spread will be part of an evolving strategy-one that recognizes the mean regression interplay of volatile stocks and macro turbulence.

Textbook concepts, although absolutely essential to fundamental understanding of option basics, are challenged by the age of program trading and artificial intelligence. Large hedge funds, in their quest to design the optimal strategy, can trigger extraordinary waves of fluctuations and volatility. It is not clear whether this type of volatility is priced in the typical option. Further, a host of new trading instruments, and the complex equations needed to support these esoteric creatures, are not adequately accounted for in typical textbooks. Even cutting edge academic papers have yet to address some of these issues. Of course, much of this is playing out in real time, and is so new, that it may be too early to offer much substantive research.

Yet, the small retail trader can prosper in this environment. Much as a survivalist is trained to live off the land, and take advantage of sudden opportunity, so it is with the small-but flexible-trader. But, it is absolutely necessary for the “survivalist trader” to be mentally prepared. This article, although brief, is an attempt to examine traditional concepts, and to foster innovative approaches that can quickly recognize and seize fleeting discontinuities.

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